Friday, February 28, 2014

The deadly undercurrent of deflation

Despite
the overall positive state of U.S. equities and the improvements in the retail
economy, the stealth enemy known as deflation is still lurking in the
shadows.

Consider
the following graph of real disposable income, courtesy of Zerohedge.com. This shows the true underlying state of the
real economy and is a testament to the continued presence of deflation.

Commenting
on the plunge in disposable real income, David K. Barker (www.marketcycledynamics.com) wrote:
“The most shocking thing about [this] is that disinflation is on the verge of deflation
when the pumps were running at $85 billion a month. The only real solution is
to restore the pricing mechanism of markets, give Mr. Market the deflation he
wants, and the global economy can move into the coming long wave spring season
sooner rather than later.”

The
good news is that the long-term deflationary cycle responsible for suppressing
income and wages is scheduled to bottom later this year. What’s troubling, however, is that deflation
wasn’t allowed to work its magic in cleansing the economy of imbalances,
including (and especially) high retail prices.
The Zero Interest Rate Policy (ZIRP) of the Federal Reserve has kept
many producers in business which should have gone out of business during the
credit crash. Moreover, ZIRP has obscured
the total impact of deflation on financial assets and consumer prices. When the next long-term inflation cycle kicks
off in 2015, we’ll be starting from a much higher price level than we would
have if deflation was allowed to proceed unchecked.

The
Fed’s monetary policies of the last few years were undertaken with the idea of
throwing everything but the kitchen sink at deflation. Politically speaking, deflation is
unacceptable to Washington since it means lower corporate profits, hence
(temporarily) lower tax revenues. The
long-term benefits of allowing deflation to run its course, however, are
boundless. With the 60-year Kress cycle
in its final year of descent, a final flare of deflationary pressure in the global
economy can’t be ruled out.

As
it turns out, even the IMF is concerned over the possibility of deflation re-emerging
this year. In a recent Businessweek article entitled, “The
Lurking Threat of Deflation,” IMF Managing Director Christine Lagarde was
quoted concerning Europe’s slow economic recovery and its potential impact on
prices. “We see rising risks of
deflation,” she said, “which could prove disastrous for the recovery.”

Lagarde’s
attitude toward deflation is made obvious by her choice of words: “Deflation is
the ogre that must be fought decisively.”
This is how virtually all central bankers and politicians feel about
deflation; it’s an “ogre” that must not be allowed to rear its ugly head. If only they had the courage and foresight to
simply stop fighting deflation and let nature take its course. The global economy would be so much the
better for it.

While
the effects of deflation aren’t discernible in U.S. stock market performance, investors
aren’t so easily fooled. They’re still
worried about the potential impact of an emerging market crisis or a China
credit crunch and they obviously believe deflation is a very real threat in the
coming months. This can be clearly seen
in the charts of two major safe haven assets, namely Treasury bonds and
gold.

Let’s
start with Treasuries. The iShares 20+
Year Treasury Bond Fund (TLT), an excellent proxy for long-term bonds, has
established a new uptrend since the start of the year. Notice that TLT is above its rising 30-day
and 60-day moving averages and is making an attempt at retracing its short-term
losses since the Feb. 3 peak.

It’s
also worth noting that the Coppock Curve indicator for TLT has recently
confirmed a turnaround signal for long bonds.
The Coppock Curve is one of the single best indicators for issuing buy
signals on bonds (though it is less helpful for determining tops). The Coppock Curve is derived by adding the
14-month and 11-month rate of changes for bond prices and smoothing the result
with a 10-month weighted moving average.
You can see in the above chart that this indicator turned up just a few days
ago and is signaling a period of outperformance for Treasuries.

The
recent Coppock Curve buy signal for bonds, assuming it pans out, means that
Treasury yields will be declining while bond prices rise. Declining yields are very much consistent
with the Kress cycle scenario for 2014, which suggests that disinflationary if
not outright deflationary pressures will increase until the long-term cycles
bottom later this year.

The
other major safe haven asset which investors have recently been flocking to is
gold. The yellow metal has rallied for
the last two months on a combination of emerging market uncertainty and
technical factors.

I’m
often asked why, if the long-term deflationary cycle is still down until,
should investors be interested in gold?
After all, isn’t gold known for being a hedge against inflation? I lately came across one very good answer to
this question. Charles Gave of GaveKavel
writes in his latest article, “Gold as a deflation hedge,” that gold becomes
for many investors the preferred substitute for international assets in a
diversified portfolio. And since the
monetary and fiscal policies of the nations is mixed and confused, gold becomes
the ideal hedge against bad policy as well as equity bear markets.

Below
is a chart produced by Gavekal Data/Macrobond.
It shows the performance of gold in Brazil’s currency versus the
country’s Bovespa stock index.

“Fed policy risk offers another
motive for gold-hoarding in emerging markets (EM),” writes Gave. “If US monetary policy adds to the volatility
of EM exchange rates, then residents need to hedge against this—and, as
mentioned, their hedging options are limited.
This is how we get the bizarre situation where holding gold protects
against devaluation and growth/deflationary pressures in the emerging markets.”

Gave’s conclusion is that gold “will keep rising as long as
US policy is exporting volatility.”